Construction Defects

Casualty Loss Reserve Seminar

Presented by:
Ronald T. Kozlowski, FCAS, Towers Perrin
Sherrianne Hanavan, RiverStone Claims Management
September 13, 2004
 California Population Growth and Housing Supply
Shortage

 In the late 70s through early 90s, California experienced

unprecedented population and housing growth
 CA population growth was twice the US population growth rate
in many periods
 Demand for housing exceeded supply
 Construction of multi-family units (condos, townhomes)
increased significantly
 Builders stepped up production
unskilled construction labor
“cut corners” - cheaper materials and built quicker
less supervision

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 Litigation Ensues

 Aggressive plaintiff’s bar

 Success in early suits funded additional suits

 Unfavorable legal decisions (discussed later)

 Construction of multi-family units (condos, townhomes)

encourages large cases
multi-family units four times more likely to sue
 Homeowners associations

sold on idea by aggressive lawyers

potential suits against condo Board if Board fails to take
action
 Spreads into other states

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 Reducing Exposures

 Many carriers exited the market starting as early as 1992

 Some carriers reduced exposure to “target classes” like

residential contractors but continued to write commercial
contractors and subcontractors
 Many carriers placed “known and continuing” endorsements or
Montrose endorsements on policies beginning as early as 1996
standard ISO Form denies coverage for claims that were
known prior to the policy period
some carriers are even more restrictive, excluding claims
first occurring prior to the policy period
 New multi-family units in California drop from 18,681 in 1994 to
2,945 in 1999
 Today many contractors looking at self-insurance and captive
options
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 Types of Defects

 Many courts have recognized two primary categories of defects

for which damages are recoverable:
defects in design, workmanship and materials
soil problems (including improper compaction, inadequate
grading, inadequate drainage, expansive soil, landslide,
earth settlement problems)

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 CD Most Commonly Alleged Defects

 Roofing  Site Work

 Sheet Metal Flashing  Metals

 Lath & Plaster  Carpentry

 Soils  Thermal & Moisture

Protection
 Rough Framing
 Finishes
 Waterproofing
 Specialties
 Doors & Windows
 Mechanical
 Concrete
 Electrical
 Painting
 Water Damage/Fungus/Dry
 Masonry
Rot/Structural Pest Control
 Design & Plan Deficiencies

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 Important Legal Cases

 I - Montrose Chemical Corp v. Superior Court (Canadian

Universal Insurance Co) - 1993
an insurer must defend an insured in case involving the
discharge of hazardous substances
even if the complaint only alleges property damage that
would trigger coverage
 II - Montrose Chemical Corp v. Admiral Insurance - 1995
continuous trigger: all insurers with potential for “property
damage” during policy period - Applies to duty defend only
does not address allocation among insurers

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 Important Legal Cases (Cont.)

 Stonewall Insurance Co. v. City of Palos Verdes Estates - 1996

first post-Montrose v. Admiral case to examine duty to

indemnify in context of construction defect claims
continuous trigger of coverage determines the obligation of
successive liability insurers to indemnify
 Combined effects:
increased ALAE due to defense requirement
more limits at risk; increased severity
multiple carriers on many claims
significant claim count increases

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 Important Legal Cases (Cont.)

 Aas v. William Lyon Company - 2000

Supreme Court decision disallowing negligence claims for

construction defects unless damage has actually occurred (a
defect without resultant damage is not sufficient for a liability
claim)
physical injury to property
does not define property damage
claims for defects must be brought under home warranties
instead
unfortunately, only removes one theory of liability and
plaintiffs have been successful using other avenues against
insurance policies

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 Important Legal Cases (Cont.)

 Presley Homes v. American States Insurance Co. - 2001

Presley tendered its defense to subcontractor’s insurer via

additional insured endorsement
insurer offered to pay share of Presley’s costs, assuming it
had duty to defend only on those suits where subcontractor
was named insured and only a portion of it
court ruled
 duty to defend applies where there is mere potential for
coverage
 duty to defend applies to entire action
effects
 shifts ALAE costs from contractor to subcontractor
 more defendants (claims), lower severity (ALAE only)
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 Statute of Limitations

 Statute of limitations
patent defects
 apparent with reasonable inspection
 statute of limitations requires claim to be submitted within
2 to 3 years of project completion
latent defects
 defect is not apparent by reasonable inspection
 more time is allowed to submit a claim, in some cases 10
years after completion (CA). For comparison purposes, AZ
is 8 years, and WA is 6 years (confirmed by WA supreme
court in September 2001)

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 “Notice and Opportunity to Repair” Legislation

 Generally provide builder with written notice and description of

alleged defects - 90 days before filing lawsuit
 California - Calderon Act - 1997
homeowners association must provide notice of a claim to
the developer and to the members of its association before
filing a lawsuit
specifically, must give written notice to the builder against
whom the claim will be made, including a list of defects
didn’t involve subcontractors and wasn’t a lawsuit
does not apply to single family homes
encourages parties to talk
final result is that filing of lawsuits gets delayed, increasing
lag time

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 “Notice and Opportunity to Repair” Legislation (Cont.)

 California - Steinberg Mandatory Negotiation Bill

effective July 1, 2002, amendment to Calderon

treat like a suit and bring subcontractors in
builders, subcontractors, insurers and suing homeowners
will be required to negotiate a solution to specific alleged
defects in a timely manner before a lawsuit can be filed
a construction defect expert will act as a referee
Bill is supported by both builders and attorneys
if cases go to trial, courts required to give these cases
priority
intended to be an improvement over Calderon

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 Other Recent Legislative Changes

 Nevada Chapter 40

allows plaintiff to recover legal costs, investigative costs, and

possibly interest, from defendant if plaintiff wins case
 California Senate Bill 800
established building standards to govern claims against
builders
established a 10 year statute of limitations
mandatory pre-lawsuit process
statutory affirmative defenses
effective January 2003
not making much of an impact, not retroactive

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 States w/ “Notice and Opportunity to Repair”
Legislation*

 Arizona, California, Colorado, Idaho, Kansas, Kentucky,

Montana, Nevada, Washington and West Virginia have adopted
 Alaska, Arkansas, Florida, Illinois, Indiana, Mississippi, Missouri,
New Mexico, Oklahoma, South Carolina, and Texas are
considering

* Based on 2003 research

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 Commonly Alleged Defects - Mold

 Water damage, mold and construction defects are intricately

related
 If the mold is caused by excess moisture which was in turn
caused by construction defects, the cost to clean up the mold
and the cost of repairs to prevent future mold may be covered
 Insurance Information Institute* estimates 10,000 mold related
lawsuits pending in U.S. - 20% involve construction defect
allegations
 52 mold related bills introduced in 20 states during 2003
legislative session
 Mold allegations being thrown in as “negotiating tool”
 Issues in AZ, CA, DC, FL, GA, LA, MI, MO, NV, NJ, NY, NC, ND,
SC, TX, WA

*Based on 2003 research

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 Commonly Alleged Defects - EIFS

 Exterior insulating finishing systems (EIFS)

 Synthetic stucco
 Water gets trapped behind the stucco and rots the frame,
plywood, and particle board
 If installed correctly, could be a manageable risk
 In the past, primarily a residential problem; may become a
commercial problem in the future: in 1997, EIFS used only on
1.5% of residential, but on 22% of commercial construction;
residential failures have not curtailed commercial applications
 Some homebuilders’ insurance companies have taken action to
exclude EIFS construction from commercial general liability
policies; insurers of commercial builders have not taken the
same action
 CA, FL, IL, LA, NC, SC, TX and NV
 Michael Jordan has a $2.6M claim
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 Common Exclusionary Endorsements

 Montrose endorsement

restricts application of continuous trigger

exists in various forms; some more effective than others
 Known loss provisions
excludes coverage where insured was aware (ISO/2001)
some exclusions apply to “known and continuing”
“deemer” provision - property losses “deemed” to have
occurred at a specific time; only one policy can be triggered
 EIFS exclusion - appears on EIFS installation contractors and
contractors tied to moisture (e.g., roofers, HVAC, plumbers,
window installers)

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 Common Exclusionary Endorsements (Cont.)

 Mold exclusions - applies to broad spectrum of contractors (e.g.,

roofers, HVAC, plumbers, window/sheetrock /siding installers,
foundation workers, landscapers)
 Earth movement exclusions - applies to contractors working on
foundations or grading; applies to earthquake prone areas
 Residential construction exclusions - carve out protection on
mainly commercial contractors/subcontractors
 “Damage to Your Work” exclusion - prevents policy from acting
as warranty on insured’s work
 Subcontractor exclusion endorsements - can add back in
damage caused by subcontractor’s work

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 Common Exclusionary Endorsements (Cont.)

 Additional insured endorsements - adds contractor as an additional

insured; questions as to whether applies to completed operations
or losses caused by insured’s own negligence (pre 1993 - all; post
1993 - “ongoing”)
 “Other insurance” - if other insurance exists this policy is excess;
recent court decision that should be treated as primary
 Endorsements generally do not eliminate coverage but rather shift
responsibility

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 Initial Investigation of a Standard CD Claim

 Determine facts needed, who would have them, and request

them
 Project site information – single family home / condominium
 Complaint, Cross-complaint, and other pleadings
 Insured’s Job Contract(s)
 Insured licensed and still in business?
 Insured’s other job file
 Nature of insured’s work
 Dates worked on & notice of completion dates
 Number of homes insured worked on

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 Initial Investigation of a Standard CD Claim (Cont.)

 Number of homes alleging defect/faulty workmanship

 Preliminary defects list

 Expert’s reports

cost of repair estimates

 Photographs or other depictions of work, defect, damage
 Breakdown between costs to repair replace insured’s own
product/work and consequential damage
 Other insurance available
named insured
additional insured

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 Calculating Time on Risk

 In a standard construction defect claim you have multiple homes

completed at different times within the same project
 The days on the risk is based on the notice of completion dates for
each home, the # of homes and the # of days on the risk per
carrier.

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 Calculating Time on Risk (Cont.)

 In a 3 home case with 12 months of coverage for a carrier:

home completed 30 days before expiration of policy

 1 home x 30 days = 30 days on risk
home completed 60 days before expiration of policy
 1 home x 60 days = 60 days on risk
home completed 90 days before expiration of policy
 1 home x 90 days = 90 days on risk

the total # of days is 180 even for a carrier with 12 months of

coverage. This sample indicates how you get the total # of
days.

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 Time on Risk Allocation Matrix

CARRIERS INCEPTION EXPIRATION DAYS ON % TIME

DATE DATE RISK ON RISK

Carrier A 12/30/1990 12/30/1991 5,056 4%

Carrier B 12/31/1991 06/26/1992 9,256 7%
6/26/92 1/1/93 0 0%
Carrier C 01/01/93 01/01/94 36,865 30%
Carrier D 01/01/94 01/01/96 73,730 59%
TOTALS 124,907 100%

*Illustrative only

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 Why Are CD Claims So Complicated?

 Definition

 Reporting lag
 Statute of limitation (patent vs. latent)

 Continuous trigger
 Multiple claimants

 Multiple defendants
 Multiple insurance companies
 Litigious environment

 Additional insured endorsements

 Changes in policy form and introduction of exclusions

 Insolvencies

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 Claim Coding - What is the Accident Date?

 Due to Montrose, the claim can trigger any policy between the
date of project completion or the date of third-party damage and
the date of remediation
 Insurers may not code claims consistently

record entire claim in policy period where project was

completed or first effective policy thereafter. As policy limits
are extinguished open up new claim on next policy
record a claim in every policy effective between completion
and remediation
record expense on only one policy or multiple

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 Coding of CD Claims to Accident Year

 Home built in 1995

 Claim reported in 2002
 Company A sold contractor policy from 1993 through 2002
Maturity

12 24 36 48 60 72 84 96
1995 1
1996
Accident Date

1997
1998
1999
2000
2001
2002
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 Coding of CD Claims to Accident Year (Cont.)

 Home built in 1995

 Claim reported in 2002
 Company A sold contractor policy from 1993 through 1998
 Company B sold contractor policy from 1999 through 2002

12 24 36 48 60 72 84 96
1995 1
1996
Accident Date

1997
1998
1999 1
2000
2001
2002
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 Coding of CD Claims to Accident Year (Cont.)

 Solution: Code claim count to each year for which a policy is exposed

Maturity

12 24 36 48 60 72 84 96
1995 1
1996 1
Accident Date

1997 1
1998 1
1999 1
2000 1
2001 1
2002 1

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 Coding of CD Claims to Accident Year (Cont.)

 Assume Montrose Endorsement added in 2000, then…..

Maturity

12 24 36 48 60 72 84 96
1995 1
1996 1
Accident Date

1997 1
1998 1
1999 1
2000
2001
2002

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 Actuarial Analysis - Issues to Address

When setting reserves, it is critical to obtain background information

on the following topics:
Exposures/Underwriting
 Policy year
 California and Other States
 Residential v. Commercial
 Developer/Contractor v. Subs/Artisans
 Changes in mix by SIC codes, class, etc.
 Primary and/or excess
 Endorsements/coverage restrictions
 Premium and exposures
 Other mitigation efforts

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 Actuarial Analysis - Issues to Address (Cont.)

Coding/Availability of Data
 By report year and accident year
 Definition of CD claim

 Coding of accident year

 Limits

 Reinsurance
 Sub-classes
additional insured endorsements
EIFS
mold

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 Actuarial Analysis - Issues to Address (Cont.)

Claim Adjusting/LAE
 Changes in claims handling philosophy
 Reserve setting practices

e.g., independent or formula reserves

 Treatment of ALAE as regards reinsurance (in or out of limit)

 Changes in reserving methodology

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 CD Reserving Methodologies

 Several methods are typically used to provide an overall picture

of the company’s reserve exposure and to test sensitivity
 For starters, obtain a claim download to facilitate detailed claim
analysis
 Reserving methods include
accident year analysis
report year analysis, including varying runoff claim estimates
using multiple claim reporting scenarios
exposure analysis
calendar year analysis
varied loss development approaches using both CD specific
and non-CD loss development factors

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 Tillinghast’s “Best Practice” Method

Combination of Report Year Loss Development and

Frequency/Severity Method for “Pure” IBNR

Ultimate Loss and ALAE =

Reported Loss and ALAE
+Supplemental development
+ Estimated Loss and ALAE IBNR

where IBNR=
IBNR claim counts
x (% claims closed with payment)
x (average future severity for claims closed with payment)

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 Tillinghast’s “Best Practice” Method (Cont.)

 Combination of Report Year Loss Development and

Frequency/Severity Method for “Pure” IBNR
once claim is reported , it is settled relatively quickly
less uncertainty for the reported loss emergence
ability to isolate changes in claims handling
allows scenario testing of pure IBNR
 varying claim counts, CWP, and severity
 For reasonability check, compare results against other methods
used
 Can allocate costs back to accident year

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 Tillinghast’s “Best Practice” Method (Cont.)

 Analyze accident year and report year data

cumulative, incremental, loss development factor basis

loss development - paid and reported, loss & ALAE
separately
claim count development - reported, CWP, CWNP
paid/reported ratios
severities - paid, paid-on-closed, reported
count ratios - closed/reported, CWP/closed, CWNP/closed
large loss data
net/gross ratios

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 Report Year Loss Estimation

 Generally, loss development approaches work well for

estimating supplemental reserves on known claims
 Take care to adjust for changes in claims handling practices
changes in claims operations (e.g., movement to specialized
units)
changes in reserving philosophy
“management’s opinion that future development will be less”
 Monitor results using diagnostic testing
examine closure rates (CWP, CWNP, CWLP, CWAP)
review reported, paid, outstanding, and ultimate severities
impact of large claims

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 Frequency Method for “Pure” IBNR

 Estimate future claim counts

claim count accident year development and Bornhuetter-

Ferguson methods
exposure base emergence
curve fitting reported to date

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 Frequency Method for “Pure” IBNR (Cont.)

 Claim count accident year development and Bornhuetter-

Ferguson methods
accident year loss development method
accident year loss development method w/ tempered LDFs
Bornhuetter-Ferguson method using premium, risk factor,
and claim frequency as initial expected claim count
reasonability check on calendar runoff

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 Frequency Method for “Pure” IBNR (Cont.)

 Exposure base emergence

assume exposures for a specific year are evenly spread out

over the statute of limitations
reorganize the exposures on an report year basis
calculate the report year frequency
apply the selected frequency against the future report year
exposures to estimate future claim emergence
see example on next page

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 Frequency Method for “Pure” IBNR (Cont.) –
Exposure Based Method – unsophisticated example
Exposure Based Method
To Estimate IBNR Claim Counts

Accident Earned Report Year

Year Exposures 1 2 3 4 5 6 7 8 9

1 10 10 10 10 10 10
2 35 35 35 35 35 35
3 60 60 60 60 60 60
4 80 80 80 80 80 80
5 50 50 50 50 50 50

(1) Report Year Exposures 10 45 105 185 235 225 190 130 50

(2) Report Year Claim Counts 2 8 18 35 40

(3) Report Year Frequency (2) / (1) 0.200 0.178 0.171 0.189 0.170

(4) Selected Frequency 0.178 0.178 0.178 0.178

(5) IBNR Claim Counts (4) x (1) 40 34 23 9

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 Frequency Method for “Pure” IBNR (Cont.)

 Curve fitting reported to date

lognormal curve fitting the report year claim emergence

curve is adjusted using two parameters
 average year of claim emergence for the peak
 coefficient of variation for the shape of the curve
target ultimate counts to minimize the sum of squares
check R-square for reasonableness
cut off claim activity at the statute of limitations
see example on next page

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 Frequency Method for “Pure” IBNR (Cont.) –
Curve Fitting Approach

Claim Count Estimation

Lognormal Curve Fit
Report Year

14.00%
12.00%
10.00%
8.00% Series1
6.00% Series2
4.00%
2.00%
0.00%
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31
Year

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 Severity Method for “Pure” IBNR

 Frequency/Severity Method for “Pure” IBNR (Cont.)

estimate CWP ratios

 select after reviewing accident year and report year data
estimate loss and ALAE severities
 using paid on closed claims
 using reported losses and estimated CWP
 make adjustments for large losses
 select trend factor

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 Trends

 Claim counts

depends upon when reduced exposure

reported peaked in 2000 to 2001, started decreasing in 2002
 mostly from mid 1990s accident years
some companies saw spike in 2003 - (could be mold or
additional insured claims)
 Severity

appears to be decreasing
larger claims settled or in litigation
impacted by more defendants
depends on contractor or subcontractor - additional insured
endorsement

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 Trends (Cont.)

 New States
AZ, CO, FL, NV, NM, NC, OR, SC, TX, WA and WY
 Developer v. subcontractor

developer used to pay 50% - 60%; now pays 20% - 30%1

developers may be running out of limits
 ALAE/Loss
ALAE currently ranges from 80% to 110% of loss
ratio rising - impacted by lower loss payments and possibly
increasing additional insured (AI) exposure

1 Thomas E. Miller, California Attorney

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 Trends (Cont.)

 CWP/Reported ratios
decreasing
quick coverage denials/”shot gun” approach
 Reinsurance
lower severities leading to less recoveries
 Consideration of insolvent insurers
remaining companies to share loss
California Insurance Guarantee Association - denies
coverage if other insurance is available
 General contractors running out of limits

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 Trends (Cont.)

 Chapter 40
Nevada law which allows plaintiff to recover legal costs,
investigative costs, and possibly interest, from defendant if
plaintiff wins case
 California Senate Bill 800
established building standards to govern claims against
builders
established a 10 year statute of limitations
mandatory pre-lawsuit process
statutory affirmative defenses
effective January 2003

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 Other Discussion Items

 Diminuation of value

 Overall severity
 Product liability

defective wood sealant - $55M judgment against Behr

Process Corp
defective shingles - $75M judgment against American
Cemwood Corp
 Legal malpractice
 Bad faith claims and punitive damages
 Real estate agents or architects
 Fault of inspector/municipality – British Columbia

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 What the Markets Are Doing?

 Underwriting rather than rating

 Exclusions
 Mandatory dispute resolution processes

 Warranty packaging
 Claims made type policies

 CCIPs (Contractor-controlled insurance programs)

 Wraps
 Captives

 SIRs/deductibles

 Use of SIRs increasing use of additional insured

endorsements

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 Contact Information

Ronald T. Kozlowski, FCAS, MAAA

Towers Perrin
525 Market St., Suite 2900
San Francisco, CA 94105-2708
Phone: (415) 836-1025
Email: ron.kozlowski@towersperrin.com

Sherrianne Hanavan
RiverStone Claims Management LLC
8880 Rio San Diego Dr.
Suite 510
San Diego, CA 92108
Phone # 619-260-8902
Email: Sherrianne_Hanavan@TRG.com

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